As inflation continues to run significantly in excess of current interest rates, the risk of deflation is not being fully addressed in pension fund planning.

It would be prudent of trustees to consider the impact that an episode of deflation would have on their pension scheme’s funding position, reflect this in their reserving calculations and consider their wider options.

According to the Bank of England, “from a historical perspective, deflation is not uncommon”. It has occurred during depressed economic conditions, such as the 1920s and 1930s, and one might categorise today’s economy as depressed. It can last for years: Japan saw consumer prices fall by an average of 0.5% per year between 1999 and 2005.

Most schemes will not reduce retirement benefits if prices go down. However, the income from any inflation-linked assets they hold will fall. This is likely to cause a deficit, especially if the period of deflation is prolonged. It is possible to obtain a market price for this risk by looking at the inflation swaps market.

This implies that the cost of hedging against this risk could be in excess of 0.6% of liabilities per year, or a one-off cost of up to 9% of liabilities as currently valued. For the combined total of UK schemes, this could push liabilities up by more than £100bn.

For pension funds that have a cap on the increases in retirement benefits – those without a cap will typically not increase their members’ annual pensions by more than 5% a year – this under-reserving might not be an issue.

Over the lifetime of the pension fund, inflation is likely to be more than 5% in some periods, and 0% in others, and the benefit from the former may offset the cost of the latter. Equally, a pension scheme with a strong sponsor should not have to worry about the risk of deflation, as it could expect the sponsor to make good any deficits.

Yet for most schemes, which are closed and therefore do not enjoy the luxury of time, there is significant danger that deflation would simply widen any existing deficit and place additional strain on the sponsor. The risk can also be crystallised even sooner, for example, when the scheme is de-risking or forced to lock into buying deflation protection following the insolvency of a sponsor.

Trustees should, therefore, be lobbying for more investments that provide deflation protection. An example would be long-dated, index-linked bonds that are structured with a floor under which payments will not reduce if inflation is negative. Trustees might usefully approach institutions such as social housing associations. These borrowers might well be open to structuring investments that provide deflation protection, because their income streams are often based on upward-only rent reviews.

Equally, there are options for schemes looking at de-risking. The pension scheme of UK wallpaper supplier Graham & Brown decided not to transfer the risk of deflation, when it entered a buy-in transaction in July. If deflation occurs, the pension scheme, backed by Graham & Brown, will have to bear the cost itself. This allowed the trustees to pay a materially reduced premium.